As taxpayers work to fund college for their children, 529 plans can provide great benefits. These types of accounts are very easy to contribute too. However, parents who are not prepared may find it hard to spend the money that they have invested without being penalized. In this article, we detail four common mistakes that people make with 529 plans.
First, some taxpayers attempt to use funds from a 529 plan to pay for expenses that are already claimed via tax credits such as the Lifetime Learning Credit or American Opportunity Credit. This is not allowed. In the same way, they cannot use these credits and deductions on expenses paid for from 529 plans.
Second, students should avoid using any distributions from grandparents’ accounts to pay tuition expenses. These distributions are viewed as giving non-taxed income to the student. This income could end up changing financial aid calculations, causing the student to lose a large portion of any scholarship or grant money they have received.
Third, taxpayers need to be careful in situations of divorce or separation. When schools determine financial aid, it is based on the financial state of the parent with whom the child lives the majority of the time. The assets of the other parent are normally not considered in the calculations. However, any distributions from the estranged parent will be added to future aid determinations. Just like funds from grandparents, distributions from a parent without custody can seriously alter financial aid calculations.
(A potential workaround for grandparents or estranged spouses who desire to contribute to a student’s college expenses is for them to transfer the funds directly to the parent. However, the IRS has never directly approved this transfer. Another option is to wait until January 1 of the student’s junior year. At this point, withdrawals will not affect aid eligibility, which is based on the previous year.)
Finally, the amount of withdrawals from a 529 plan must match the amount of qualified expenses that the student incurred. These “qualified expenses” include tuition and books, but do not include things such as computers, electronics, transportation or repayment of loans. You must also subtract any scholarships or grants from the total expenses.
529 plans bring many benefits, but taxpayers must ensure that they have a withdrawal strategy to accompany the plan. Otherwise, their distributions may end up being taxed and penalized, and the student may end up losing valuable financial aid, scholarships or grants.